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Equity Multiplier

May 30, 2012 | Comments: 0 | Views: 137

Let's take the balance formula as example: Total assets are equal to the sum of equity and liabilities. As you can see in the equity multiplier formula, only assets and equity is taken into consideration. It means that if this ratio between assets and equity is equal to 1, there are no liabilities in the company. It also means that more of the shareholder's equity is covered by assets, so shareholders can feel safer.

Usually it is barely impossible that company doesn't have liabilities at all, so it means, that this ratio will never be equal to 1, but if the company is big and the amounts of liabilities are not so numerous, the value of the ratio might be very close to 1. But if we take the company that has some loans or other liabilities (i.e. debt for suppliers), we will get higher value of equity multiplier ratio. And the higher the debt is the higher this ratio will be.

Higher equity multiplier ratio shows that the company has higher leverage, and more of the assets are financed by borrowed funds rather than equity. If the debt level is high, the shareholders should be aware of the actions of the company, because their money is not as safe as in a company with a lower equity multiplier ratio. Actually, this ratio shows how many of assets supports with each euro of capital.

Let's take an example - here is a company that has a balance with 100.000 Euros of assets and 3.000 Euros of Liabilities. Shareholders equity for this company is 97.000 Euros. If we calculate the equity multiplier, we get that it is equal to 1,03. As it was said earlier, the company cannot have zero of liabilities, but a very small amount of it gives a low ratio which shows the reliability of the company.

The other example will illustrate a more leveraged company, which has a balance of the same 100.000 Euros of assets and only 10.000 Euros of equity, which means that 90.000 Euros are the liabilities, which can be the debt for the suppliers or the loan from the bank. This ratio for this example is equal to 10, which means that the company is highly leveraged, and if the company will go bankrupt, firstly the loans in the bank should be paid and only after that the shareholders might get their invested money, what happens very rarely.

If we use logic, we can foresee that for small companies this ratio is usually higher than for large companies, but if a large company makes an acquisition or some bigger investment, its equity multiplier might be even bigger than for a small company. So the level of ratio depends on the size of the company and the amount of liabilities share in the balance.

For the investor it is always useful to calculate leverage ratios to see what the financial situation in the company is. The equity multiplier ratio is mostly used to measure the level of assets that is financed by debt rather than equity. We might say that this ratio shows the level of safety for the investor. The higher ratio is the more risky investment it will be.

Equity multiplier calculator and many other financial calculators can be found here:

Source: EzineArticles
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